Guide to Estate Planning - The Perfect Storm

With Two Laws Set to Expire, a Sagging Economy, Legislative Uncertainty and an Aging Population, 2009 Could Become Known as the “Year of Estate Planning”

By Dave Malaska

While the nation’s attention is pulled to dreary economic news, and newspaper headlines blare about bears on Wall Street, skyrocketing fuel prices and record home foreclosures, another big financial story is waiting just off-stage. Estate planning, including wills, various trusts and other mechanisms to help heirs avoid an unnecessary IRS tax bite, is about to take center stage. A confluence of economic factors, legislative uncertainty and an aging population may make 2009 the “year of estate planning.”

“We’re on the verge of a very large group, baby boomers, passing along their fortunes, and the focus will be on protecting that wealth from estate taxes, from creditors, from lawsuits, from the ever-changing dynamics of families,” advises Ellis Hummel, vice president and portfolio manager with Downtown-based Bahl & Gaynor Investment Counsel.

As Hummel points out, not only are boomers in “the zone” for planning activity, they’re more likely to have blended families and other complexities, such as children working in fields where they’re more likely to face lawsuits, that make planning for their heirs’ future a frontline concern. “They need to make sure that the wealth they’ve created is transferred in a way they intended,” he says.

Boomers aren’t the only ones who are going to be hearing a lot more about estate planning, though.

Fueling that soon-to-be front-page status is the possible expiration of the Economic Growth and Tax Relief Reconciliation Act of 2001. The law, pushed through Congress in June 2001, mostly through Republican efforts, was aimed at raising the bar on how much wealth people could leave their heirs before taxes. Two years later, Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003 to accelerate the nine-year structure of the legislation.

Both are scheduled to expire in 2010.

Under the 2001 law, a married couple can currently shelter about $4 million — $2 million for each spouse — of an estate through simple trust work, says Rick Krawczeski, Western & Southern Financial Group vice president of financial planning. For single people, it’s $2 million. Estates valued over those limits are taxed at a 45 percent rate. That will soon change, however. “We’ll have this $2 million exemption until the end of this year, when it changes to $3.5 million in 2009, and then in 2010, the estate tax will be repealed. If it’s not addressed by Congress, there won’t be a federal estate tax,” Krawczeski reports. The result would be a year without the federal government taking what can be a large piece of passed-down wealth.

An economic hangover would loom just around the corner, though. If Congress merely lets the current law expire, the limit will fall back to the pre-legislation limit of $1 million for individuals and $2 million for couples in 2011 — levels easily surpassed by many families with retirement plans, life insurance, homes and even minimal assets. “So, suddenly, someone who’s been in a non-taxable situation for a number of years would suddenly find themselves in a heavily taxable situation,” Krawczeski explains. The euphoria of a tax-free 2010 would quickly plummet.

Ken Schoster, a principal and director of the Mount Adams office Rippe & Kingston, spells out the downside of congressional inaction. “If nothing happens between now and then, (estate taxes) come back with a vengeance in 2011. It’s kind of tongue-in-cheek, but we’re telling our people that if you can plan your death, plan it for 2010.”

Still, local experts aren’t holding their breath that all this will come to pass. These provisions are the fourth version of estate tax law Washington has enacted, and though the tax has been repealed three times before, it’s historically been brought back to either help stabilize a weak economy or fund a war effort, experts point out. Both elements are in play for this latest round of legislative uncertainty. The financial community consensus is that Congress will address estate taxes next year, a significantly non-election year in which legislators will feel more comfortable dealing with the unpopular issue.

“Realistically, the folks in Washington won’t let the estate tax expire,” Schoster explains. “Congress is probably going to put it in their back pocket until next year. Then, they’ll probably move to fix it whether they put in a higher exemption or lock the rate in at 45 percent. I don’t think either party has an interest in eliminating (estate taxes). It’s not popular because it’s viewed as a tax break for the rich.”

Unpopular a topic as it is, however, estate taxes haven’t been a podium topic for presidential candidates John McCain and Barack Obama, though both have floated ideas for what should happen next. Obama, the Democratic senator from Illinois, has voiced a willingness to freeze both the exemption limit and tax rate at 2009 levels, adding graded increases for inflation over time. McCain, the Republican senator from Arizona, meanwhile, has advocated a more radical change: A $5 million exemption level per individual, with a greatly reduced 15 percent tax rate on anything over that limit.

In fact, Congress nearly moved on provisions that mirror McCain’s plan last year, says tax attorney and CPA Bill Hesch, whose Oakley law firm specializes in estate planning. “It’s exactly what people were talking about for a couple of years, and came close to passing in 2007,” Hesch says. “Ultimately, the Democrats balked because they wanted to retain the $3.5 million exemption, or at least something closer to it.”

That would put estate taxes more in line with capital gains taxes already on the books — a goal of proponents — in a call for tax “fairness.”

It’s unlikely to become a large campaign battle cry this fall, though. In the grand picture, the candidates’ views aren’t that far apart. “They may not agree on many things, but they both agree that estate taxes aren’t going anywhere anytime soon,” quips Kevin Ghassomian, a partner with Greenebaum Doll & McDonald PLLC’s Cincinnati and Covington offices.

And, because Congress holds the purse strings, he says, this November’s election results will not likely carry much weight when Congress moves. “I think what you can expect is an exemption amount that’s closer to 3.5 million than 5 million,” he says. Krawczeski agrees. “I can’t imagine, given budget constraints, they’re going to get any more lax with this and allow people to shelter more of their estate. But it’s anybody’s guess, and we really won’t know until next year. From what I’m reading, they’re leaning towards freezing it at the $3.5 million exemption, but that’s worth the paper it’s written on at this point,” he adds.

While planners take a wait-and-see approach to what becomes of the sunset provisions, or dates the laws are scheduled to expire, the economy is affording huge opportunities for their clients to slash their estate tax liability. Oddly enough, the depressed stock market and government’s attempt to stabilize the economy by lowering interest rates are giving estate-planning tools that have been around for decades a new appeal.

Planners are advising their clients to pass along some of their wealth now, rather than later, to cut the value of their estates when they pass. Doing that, they’ll also avoid the much-higher 45 percent estate tax rate. “The basic strategy is ‘what’s the best way to have to pay the least amount of taxes?’ because you’re going to pay some taxes,” Krawczeski explains.

Options to avoiding the biggest tax bites include cash gifts, low-interest loans to family members or the sale of value-depressed assets with potential for growth.

The simplest mechanism is a simple loan or sale of assets to your children, charging them the federal minimum interest rate. By doing that, clients not only cut their estate value for tax purposes, but transfer wealth to their heirs at a far lower tax rate than what the IRS would levy with the estate tax.

If parents want to shift money to a child, Ghassomian notes, they need to be careful to avoid the gift tax, which is assessed on gratuitous lifetime transfers at a top rate of 45 percent. Fortunately, if the gift from a parent to a child is under $12,000 (or $24,000 in the case of a married couple) there are no tax consequences. This yearly tax-free gift amount is known as the “annual exclusion.”

Parents with significant wealth, however, may want to shift more to the children than the annual exclusion allows, Ghassomian adds, especially if the parents are facing a significant estate tax liability. One simple way to do this, he say, is by making an intra-family loan (from parent to child). For the loan to pass muster with the IRS, the parent must charge interest at the applicable federal rate. “In a low interest rate environment like the one we have now, the AFR is very reasonable,” Ghassomian remarks, “thus, such intra-family loans make sense — in short, because loans are not subject to gift tax.

“Using these techniques, you can pass along much more than the $12,000 annual exclusion from gift tax,” Ghassomian continues. “That’s because you’re not making a gift, you’re entering into a transaction. Portfolios are depressed because the market is down, and with the interest rate so low, you can really shift a significant amount of wealth in the current environment.”

Schoster agrees: “The assets you want to move out of your estate are the ones that have the most potential for appreciation. For instance, if you have a stock that’s worth $100 today, and you think it’s going to be worth $1,000 in five years, you’re best off moving that out of your estate and letting your children pay the tax on its current value, rather than waiting and having them liable for the tax on the $1,000 value.”

Another “hot” mechanism for business owners is a Grantor Retained Annuity Trust — a GRAT, in industry-speak — in which you give away assets in return for an annuity payment for a fixed number of years. After that period, the business transfers to your children. Because heirs will pay a gift tax on the difference between the value of the business at the time a GRAT is set up and the total of the annuity payments, they are often left with little tax liability through scrupulous planning. Experts say strategies such as setting up an installment sale of assets to heirs will help avoid a 45 percent tax rate from the IRS.

“When you’re looking down the barrel of that tax,” Ghassomian says, “you find ways of taking action so that Uncle Sam doesn’t turn out to be your primary beneficiary.” The key, experts agree, is to consult an estate-planning professional to keep your estate plans current and complete to avoid mistakes that — as Ghassomian says — could have “a lot of zeroes at the end of them.”

“Estate planning isn’t just about money. It’s about your life, your family’s life,” Hummel offers. “It’s about living wills, about who’s going to take care of your kids and how they’re going to pay for that care, and a whole list of ancillary concerns. These issues affect not only the wealthy, but people building their wealth, too. My father always said, ‘if you have the ability, buy the brains.’ Let an expert take care of this aspect of your life.”

Setting up an initial plan could cost as little as a few hundred dollars, with minor charges for periodic updates and revisions over the years. Even at that rate, it would be well worth the effort to avoid mistakes that could cost your family thousands of dollars in an attempt to do it yourself.

Suzanne Land, a member of the wealth transfer team at Greenebaum Doll & McDonald, says that even as clients learn more about what they can do with their assets, they shouldn’t take action without consulting a professional.

“People just want to do more with what they have, and there’s just so much more information available to them,” she says. “Clients are becoming more educated. There’s more information in the media, more written information, more on TV, and just so much more access to information.”

Complexities of estate law are sure stumbling blocks for the uninitiated, causing mistakes that planners can help their clients avoid. Undervaluing your estate, by not accounting for all your assets, is a major mistake. “Some people just don’t consider themselves wealthy, but by all measures are,” Krawczeski says. “They live more the middle-income lifestyle, yet if their estates were evaluated by the IRS, they would exceed the limits that put them into a wealthy category. That’s the opinion that matters: the IRS’s. A professional would catch that.”

Experts say another common pitfall is not taking into account conflicting documents.

For a number of people, especially longtime employees of Fortune 500 companies such as Procter & Gamble and GE, the lion’s share of their wealth could be tied into retirement accounts and life insurance policies, each with its own beneficiary designation, its own directive as to who benefits should be allocated. It’s easy to assume a will would trump anything contained in those plans, but it doesn’t, Hesch explains. “The assets in your retirement plan and life insurance plans pass in accordance to the beneficiary designation form you fill out with the plans’ custodian, not your will. So, you haven’t really solidified your estate plans until you’ve dotted the i’s and crossed the t’s on something like this. If you have a will and an estate plan, but you haven’t addressed the beneficiaries named in those plans, what’s the point? You’ve ignored the lion’s share of your wealth and how it will be transferred.”

How those plans are owned could also affect the tax rate the beneficiaries will shoulder.

The largest error, though, is not having any plan in place at all, whether it’s from procrastination or a reluctance to face the topic of death. “About half the people I deal with don’t have an estate plan, not even a will — and these are people who have raised a family, worked and lived through life. It’s human nature to procrastinate, especially when it comes to our mortality,” Krawczeski says. “For some people, it’s like ‘If I get a will, it means I’m going to die; therefore, if I don’t set up a will, I’m going to live forever!’ They just have that game going on in their head. But if you don’t have a plan set up, the state has one for you. It’s probably not going to be one you’d like.”

Positive Changes for Families

While awaiting news of how Congress will act on the issue of estate planning, small changes have come that could help families immensely.

One change, impacting surviving spouses in particular, could end up saving them tens of thousands of dollars. Last year, legislators widened the barrier for surviving spouses to sell their home without suffering a larger tax hit.

“Not many people were aware of the law, even before it changed,” Krawczeski explains. “When you own a house with your spouse, you can sell the home and shelter up to $500,000 in capital gains as a couple. If a single person sells the home, he or she can only shelter $250,000. So, what has happened to a number of people over the years is that a couple owns a home and lives in it most of their lives, then one spouse dies. The survivor stays in the home, then decides to sell it later, and can only shelter $250,000 because they’re single.”

Previously, the surviving spouse had one year to sell the home and shelter $500,000. Now, he or she has two years to sell the home.

The change, Krawczeski says, is “one of the positive changes we’ve seen. We don’t see too many of those.

“The year after a husband or wife dies, it’s a hard time to make that kind of decision. You’re in emotional turmoil. Many people would stay in the house, sold later and just suffered the consequences.”

“Estate planning isn’t just about money. It’s about your life, your family’s life. It’s about living wills, about who’s going to take care of your kids and how they’re going to pay for that care ...” Other tips for couples:

1) Plan two steps ahead. If your primary beneficiary isn’t around to collect, and no secondary beneficiary is named, courts decide what happens to your assets. Name multiple primary and secondary beneficiaries. “Plan for the worst-case scenario; not the most likely case,” Hesch advises.

2) You can leave an unlimited amount to your spouse tax-free, but it’s generally not a good idea. By leaving all your assets to your spouse, you don’t take advantage of your estate tax exemptions and increase the survivor’s estate, leaving a larger tax debt for your children when they inherit.

3) One simple way to reduce your taxable estate is to pay for tuition or medical expenses for grandchildren. So long as the money is paid directly to the educational institution or doctor, there’s no gift tax, and it doesn’t use up your annual exclusions.

4) Discuss your estate plans with heirs. Inheritance can be a sticky issue with families in turmoil after a loss. Be clear up front and help dissipate family conflicts that could arise after you’ve gone.

Gift Taxes: Know the RulesThese are answers to some questions posed frequently to the U.S. Internal Revenue Service about federal gift taxes. For more information, go to www.irs.gov and be sure to consult with tax professionals before making decisions.

What can be excludedfrom gifts?The general rule is that any gift is a taxable gift. However, there are many exceptions to this rule. Generally, the following gifts are not taxable gifts:• Gifts that are not more than the annual exclusion for the calendar year.• Tuition or medical expenses you pay for someone (the educational and medical exclusions).• Gifts to your spouse.• Gifts to a political organization for its use.• Gifts to qualifying charities are deductible from the value of the gift(s) made.

May I deduct gifts on my income tax return?Making a gift or leaving your estate to your heirs does not ordinarily affect your federal income tax. You cannot deduct the value of gifts you make (other than gifts that are deductible charitable contributions).

How many annual exclusions are available?The annual exclusion applies to gifts to each donee.

What is “Fair Market Value?”According to the IRS web site, “the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate.”

What if I sell property that has been given to me?The general rule is that your basis in the property is the same as the basis of the donor. For example, if you were given stock that the donor had purchased for $10 per share (and that was his/her basis), and you later sold it for $100 per share, you would pay income tax on a gain of $90 per share. (Note: The rules are different for property acquired from an estate.)

Where They Stand On the Estate Tax

Neither presidential candidate has supported abolishing federal estate taxes, but they differ considerably in their current positions.

McCain calls for a permanent reduction in the estate tax in 2010 by increasing the amount of estate assets excluded from taxation to $5 million and lowering the estate tax rate from 45 percent to 15 percent.* He also would make permanent the current federal deduction allowed for estate taxes paid to states, instead of restoring the more generous federal tax credit that used to apply.

Obama’s plan would permanently fix the estate tax law in its 2009 form: an exemption on the first $3.5 million of estate assets and a top rate of 45 percent. “We assume the exemption would remain fixed in nominal terms as it is under current law and that state estate taxes would remain deductible and not revert to a credit,” say analysts at The Tax Policy Center.

* Current law reduces the estate tax in 2009, and eliminates it entirely in 2010. If the 2001 tax cuts expire in 2011, the estate tax exemption would fall back to $1 million and the estate tax rate would revert back to 55 percent.